Vote for a rate cut or don't vote at all

Open letter to Mervyn King, Bank of England governor, and members of the Monetary Policy Committee

BY now you'll be inundated by submissions on this week's meeting over interest rates. My executive summary at least has the merit of brevity: if you aren't planning to cut rates on Thursday, do the country a favour and take the day off to go Christmas shopping. Indeed, whether you cut or not is starting to look academic.

There can hardly be a thinking person left in Britain who has not noticed the business headlines and the black storm clouds now upon us. Barely a day has passed without news of more troubles in the financial sector, figures on slumping mortgage lending and house prices starting to fall in many areas.

Just to make sure we're on the same page, this month has seen, according to the Nationwide, the biggest drop in house prices for 12 years with a 0.8% decline in November from October. And the Bank's own figures show that the monthly volume of new mortgage approvals has dropped by over 20% between October and July - at the outset of the credit crunch.

That is an astonishing drop and points to the possibility of a big house price fall. In the money markets the crisis of confidence is now so severe that the three-month London Inter Bank Rate has now shot up to 6.6%. This is consistent with the Bank of England base rate at 6-6.25%.

So while members of the Committee have agonised over whether to cut rates or not, effective interest rates have gone up! And I do now wonder whether, even if you do cut rates by a quarter of a percentage point this Thursday, it will make a jot or a tittle of difference to consumer behaviour or those household inflation expectations that so worry you. I do not see mortgage interest rates coming down as a result, or credit card interest rates for that matter. So what changes in the real world?

The fact is that such is the appalling state of confidence in the financial sector that banks have become extremely nervous of commercial paper. And for those mortgage institutions still dependent on wholesale funds for the money they lend on to home buyers, it's perhaps as well that mortgage approvals have tanked as the money to finance them is unavailable, other than at penal rates.

A massive squeeze is now under way. And in these conditions it is hard to see how concerns over inflation should continue to override worries about the downturn now happening. It would be comforting to think that the Bank could make some attempt to regain control of the situation as tightening to this extent surely constitutes an authorised policy overshooting. No meeting of the MPC authorised a rise in interest rates to this level. So what's the point in having an MPC? Indeed, if you wanted to add to the turmoil in financial markets by bringing about a severe fall in the housing market and the wider economy, I could hardly think of a better way to do it than to carry on as if rates for wholesale money were irrelevant or unimportant.

There is another point you should consider. At several points in the 10-year history of the MPC it was frequently argued that a small rise in interest rates before the economy began overheating would prevent a much sharper rise further on. Indeed, this was one of the key arguments for monthly meetings of the committee and the flexibility it made possible to tighten policy in gentle adjustments without waiting for events to force a much sharper slamming on the brakes. This 'smoothing' argument, it was said, worked to maintain order and stability in markets and worked in favour of policy predictability.

But the argument, of course, applies just as much in reverse. When there are signs of storms ahead, official rates can be cut to a gentle degree to enable a cushioning effect to work, so that downturns need not be as severe as they might have been. Delay such action - as you did in October, November and look set to do this week - and it means that rates will have to be cut further and longer than otherwise would have been the case.

Thus the latest assessment from Michael Saunders, UK economist at Citigroup: "The financial market crisis is intensifying, while housing demand is plunging in response to high interest rates, high household debts and reduced credit availability.

"We continue to expect that economic weakness will prompt the MPC to ease markedly in the next two to three quarters. Indeed, delay may - by exacerbating the economic slowdown - imply greater eventual easing." Forward markets are already discounting base rate cuts down to 4.75%.

I appreciate you like to keep your cards close to your chests, but recent remarks by five of the seven 'no change' members of the committee since the last meeting are of public interest as they show why you are so reluctant to cut. All indicate a continuing concern over inflation. So while the economy has almost certainly entered a slowdown, Howard Archer, economist at Global Horizons, puts the odds at around 6/4 in favour of unchanged interest rates this week. But there are two other points, in addition to the key one about tighter monetary policy, you should consider.

Yes, the Retail Price Index (RPI) or 'headline' inflation measure is indeed still uncomfortably high at 4.2%, well above the target CPI measure (2.1%). And I know that some of you are worried that it is the headline rate that drives inflation expectations. But the main reason for the difference between the two inflation measures is housing. While housing components such as mortgage interest payments and depreciation are not included in the CPI measure, they account for some 10% of the RPI. Should the rise in these components fall to zero, the RPI overall would fall to below 2.5%. And that is what is starting to happen now. Once the reality sinks home that house prices are indeed falling, then inflation expectations will follow suit.

And second, while last week's CBI Distributive Trade Survey did show prices being marked up strongly, the Purchasing Managers Index is likely to tell a different story - and one that testifies more immediately to the severity of the slowdown under way. An MPC shopping trip would do more for the economy than a 'no change' vote. But that would make radical action in the New Year all the more necessary.

Don't go mad with the card.